Will Deener: In stock picking, avoiding big losses is more important than getting a big win

Market experts consider the period from 1983 through 2007 one of the grandest bull markets in history.

The market was up tenfold during those 24 years, and yet almost 40 percent of the stocks in the Russell 3000 index lost money. That’s right. About two out of every five stocks dropped during this period, and one out of every five stocks lost 75 percent of their value.

That is why successful stock picking is difficult, tedious and time-consuming. Even during good times, many stocks underperform, and it’s even worse during weak economic periods.

I was chatting about this topic recently with John Del Vecchio, co-manager of the Dallas-based Active Bear exchange traded fund, and he put it this way:

“Most people believe that over time stocks go up, but that’s not exactly true. Actually, stock indices go up, but many individual stocks underperform.”

Del Vecchio, 36, and his partner Brad Lamensdorf manage more than $300 million in the Active Bear fund and specialize in shorting stocks — betting they will drop. He also recently co-wrote a book titled What’s Behind the Numbers, in which he lays bare the accounting gimmickry and corporate smokescreens used in financial reporting.

I would recommend the book to those compelled toward stock picking or to anyone who wants to better understand how companies manipulate their earnings. It’s an easy read — you don’t need an accounting degree to understand it — and the insights are applicable whether you prefer to go long or short.

Revenue manipulation

One of the book’s key points is that many companies, especially struggling ones, manipulate their top line revenue, and this throws all of the financial statements out of kilter — the income statement, cash flow statement and the balance sheet.

The Financial Accounting Standards Board gives companies a lot of wiggle room as to when and how they book revenue. But with a little effort and some simple arithmetic, savvy investors can detect revenue manipulation and avoid taking those big stock losses.

“Revenue is the top line of the income statement for a reason. It is the lifeblood of any company,” Del Vecchio writes. “Any doubt about the sustainability of revenue throws the rest of the financial model into question. The financial fish rots from the revenue head.”

Revenue can be manipulated in many ways, but one of the most prevalent strategies is what is called “stuffing the channel.”

Say, for example, that two days before the end of a quarter, company executives realize they have booked only 80 percent of the revenue Wall Street analysts are expecting.

They know they have other orders in the pipeline for the next quarter, so they simply contact those customers and offer discounted prices and more time to pay — 180 days instead of 90 days. In other words, they are pulling sales out of a future quarter and putting that revenue into the current quarter to meet expectations.

To determine if a company is stuffing the channel, simply look at the balance sheet over several quarters and calculate the percentage or ratio of accounts receivables to sales. For a company with $10 in accounts receivables and $100 in sales, the ratio is 10 percent. If that increases to 15 percent, then to 20 percent and higher, channel stuffing is probably in play.

The point is that companies with strong demand for their products and services don’t need to pull revenue forward. It’s an early warning sign of trouble if they do. And be aware that companies will use code words to mask this, such as “heavily back-end-loaded quarter.”

Those special charges

The meaning is the same. The company is discounting and offering special financing to “feed the Street,” Del Vecchio said. His book is chock full of other examples, but another one that caught my eye involved companies that rely heavily on special or one-time charges.

Wall Street analysts often will ignore these charges in their calculations of earnings per share because they are not expected to continue. That’s fine when they are truly nonrecurring, but companies that chronically have their income statements littered with these charges should be avoided because determining real earnings will be difficult.

A good example of a company overusing special charges is Hewlett-Packard Co. This company has reported 12 consecutive quarters of restructuring and other special charges.

“No one can figure out what Hewlett-Packard’s earning power is,” Del Vecchio said. “Investors should run from companies with serial one-time charges.”

Investors who detected this issue a couple of years ago would have avoided watching their shares drop from above $50 a share to below $14 today. That is the kind of loss that will wreck a portfolio.

Avoiding the big losses is more important than getting the big win, and that is the message of this book.

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